The term “fiscal cliff” refers to a series of fiscal events set to unfold in U.S. at the end of this year and in early 2013. These include:

·   Expiration of the Bush-era tax cuts at the end of 2012, including current lower tax rates on capital gains, dividends, income, and estates, as well as number of other measures.

·   Expiration of fiscal stimulus measures, such as a 2-percentage-point cut in Social Security payroll taxes and extended unemployment benefits.

·   Spending cuts of $ 1 trillion over 10 years – which Congress approved during the Republican-led standoff over raising the federal debt ceiling in 2011 – will start kicking at the beginning of 2013. .

Without a broad consensus among Republican and Democrat lawmakers to ensure the required Congressional action before the end of this December, up to $600 billion of expiring tax cuts, the levy of new taxes and automatic spending cuts to the tune of $ 200 billion are set to take effect at the beginning of 2013. That’s equal to about four percent of US GDP, which is likely to plunge US economy into a recession. The expected immediate collapse of financial markets due to these fiscal measures is coined as “Fiscal Cliff”.

It’s a double-edged sword. If the US government rolls back all expiring tax-cuts and implement spending cuts, it will be able to address both short and medium-term deficit problems - debt held by the public will fall to only 58 percent of GDP by 2022, below the 60 percent mark that many economists warn against exceeding. However, it will also result in a weakened economy that may fall into a recession, and unemployment will spike up to 9.1 percent from its current level of 7.9 percent. On the other hand, if all policies, including the payroll tax cuts, are extended, the economy will grow 2.4 percent but debt would also climb to 90 percent of GDP.

Therefore, the Congress and the White House need to work on a plan that uses a balanced approach. In the less likely scenario that Congress and the White House fail to reach any compromise whatsoever and are unable even to agree on how to delay the looming measures, there would be major consequences for global financial markets.

A recession in the US economy, coupled with the sagging European economies and a slowdown in China’s growth could really hurt the world markets.

According to a recent Bank of America Merrill Lynch fund manager survey, nearly three-quarters (72 percent) of global investors believe that the fiscal cliff is not substantially priced into global equities and macroeconomic data. The fiscal cliff is identified as the number one tail risk by 42 per cent of respondents – up from 35 per cent in September and 26 per cent in August.

Markets have been working on the assumption that the U.S. is going to address the fiscal cliff challenge with a more gradual adjustment. Should a falling off the cliff really happen, the global stock markets would go in for a major correction.

For further reading, please follow the below link:

http://en.wikipedia.org/wiki/Fiscal_cliff

This is a strange pair of two markets, Saudi Arabia and India. One is a rich oil producer sitting on huge amount of wealth and is 7 times richer than India on a per capita basis. Another is a growing emerging market three times the size of Saudi Arabia.

On the 31^st of January 2005 the TASI index was at a modest 8,231 points while the SENSEX was at its modest 6,555 points. Since that date the TASI index peaked at 20,643 points on 28/02/2006 while the SENSEX peaked to 20,286 points on 31/12/2007. The global credit crisis in 2008 brought them down together (as they did to all the markets in the world) with their bottoms reaching during February 2009 shedding 79% and 56% respectively (from peak) of their values. However since that date SENSEX bounced back to post a return of over 100% while Saudi Arabia totters. This has created a chasm between the two markets in terms of long term returns. During the last 5 years, Sensex produced a negative annualized return of 2% against negative annualized return of 5% for Saudi Arabia. Strangely enough oil prices seem to correlate more to Sensex than to Saudi index TASI (may be spurious correlation!).

Obviously this bounce back for India has produced some valuation excesses compared to Saudi Arabia. India currently trades at a p/e level of 15 (median is 16.5) while Saudi Arabia trades at 12 (median 14). Due to low valuation, Saudi offers better dividend yield (4.1%) compared to India’s 1.4%.

For the future, the following scenarios emerge:

1.       The differential gap narrows with Saudi rising and India staying put or falling

2.       The differential gap widens with India keeping up the bull momentum and Saudi straying sideways as has been the trend of late

3.       The differential gap stays put with either both markets witnessing upward moment or both markets witnessing side way movement.

We would go with 1 above since valuation for Saudi Arabia borders on reasonable, government spending remaining strong, and oil price continuing to maintain strength. Time for pair trading among uncorrelated markets!

We have been regularly monitoring analysts’ recommendations in GCC and notice a weird trend. Most of the calls are either buy or hold. Look at the table below:

Table 1- Recommendations Vs the S&P GCC

Since 2010, analysts scream either a buy or hold nearly 90% of the time. In the 2.5 years of study, only during 2H 2010 the market turned reasonably positive validating the scream. In all the other cases, the market movement was totally in contrast to the scream, especially during 2H 2011 when markets tanked 8.2% while 96% of recommendations were either buy or hold. This applies even at stock specific levels. We produce below some instances where analysts steadfastly screamed buy regardless of sharp drop in share price and side way movement for a long time.

Etisalat is a classic example where analysts were screaming buy from Dhs 16 all the way to Dhs 6.5! Thereafter the stock moved sideways since the last 2 years and even then analysts still screamed buy all the way. Another good example would be First Gulf Bank.

Analysts screamed buy when the stock was quoting at Dhs 13 and they continue to yell buy till the stock tanked to Dhs 4! After this episode, we notice a string of buy recommendations and some hold recommendations while the stock moved sideways for the last 2 years.

While we did not notice buy screams for Industries Qatar at the peak of the market in 2008, we noticed several hold and buy recommendations during the last few years when the stock performance was more or less flat.

So, the aggregate data presented in the tables above as well as stock level calls presented clearly point to one trend: analyst’s pre disposition to scream buy or hold rather than sell. We must say here that it is quite possible that we may have missed out on some recommendations especially those research notes that are proprietary and are not freely available for public viewing. In spite of this failing, we still believe that analysts are more prone to issue a buy/hold rating on a stock in GCC than sell.

It is interesting to understand the psychology behind this phenomenon which we espoused in our earlier blog and we feel they still stand the test. Here is our list of reasoning:

1. Buy recommendations can be acted upon even by new investors (suits the agenda of sell side brokers) while sell recommendations can only be acted by those who hold them (small universe)

2. Sell recommendations are almost always unpopular with companies and hence will not serve investment banking needs and other favours.

3. Sell recommendations are not acted upon as much as buy recommendations as it means accepting a mistake. (Behavioural finance!). It is difficult to take small loss than a poor but positive return.

4. Analysts are well served by companies they research when they give buy recommendation. They will have more access to information (extremely critical in GCC) next time around since they are in good books of the company.

5. In the GCC, absence of derivatives market makes it difficult to action sell recommendations except by portfolio managers. Even where derivatives market enables one to short, since the loss on short position tends to be unlimited, it has limited application (given the risk management pressure).

For these reasons, we believe GCC will be a “buyers” market for some time to come.

M.R. Raghu, CFA
Humoud Al-Sabah

Executive Summary

Kuwait Top 15 Index was introduced to mirror the performance of the market as a whole while making it easier for fund managers to track the index by reducing costs and liquidity concerns. The Kuwait 15 differs from the Kuwait weighted Index and the Price index since it only takes into consideration the top 15 companies according to liquidity and size rather than taking the whole universe which contains hard to invest companies due to minuscule size and low liquidity.

Selection Process

International accessibility

Kuwait 15 Index (K15) simplifies investment procedures for fund managers and foreign investors demanding exposure on the Kuwaiti market since the market is top heavy, it makes little sense for index trackers (I.E ETFs) to be fully invested in KSE weighted index and/ or Kuwait Price index in order to mimic the movement of the Index. The K15 index will simplify the process of Index investment; reduce transaction costs and liquidity risks while maintaining low tracking error (since fund managers will only invest in 15 companies rather than 105)

Non-Oil GDP contribution

One of the main reasons for choosing the KW15 index was “ to be a bellwether indicator of the Kuwait Economy1” we checked this hypothesis by looking at the non-oil GDP contribution of the top 3 contributors2; Financial institutions, Transport storage and Communication and to some extent whole Sale and retail trade. Our findings shows that currently the Kuwait 15 index represents 57% of Non-oil GDP thus it could be used as a “rough” indicator on economic conditions



Limitation

The current structure of K15 gives the optimal exposure on KSE market movement however; missed opportunities from investing in this index might arise including:

1) The index is currently over-exposed to the banking sector; hence it could not accurately gauge performance in other sectors.
2) Although effective in gauging market sentiment, active medium-cap style managers will have larger tracking error since mid-caps are nowhere near the top 15 index.




View Kuwait 15 Index factsheet

How true…It requires tremendous courage to forecast especially when you have the strongest financial crisis hitting the world. Now is the time when investment banks would come out with their forecast for 2011. But, firstly how did they do in 2010. This is the purpose of this write-up and look closely at calls on US Economy, S&P 500, Emerging markets and commodities

US Economy

Table 1 GDP Data

Source: Birinyi associates Inc and the institute of international Finance

The forecast for US growth ranged from a low of 2.1% by Goldman Sachs to a high of 4.9% by Deutsche Bank with the actual growth coming in at 2.7%. Most of them erred on the high side implying that the expectation was mostly bullish.

S&P 500

The actual outcome was very close to the consensus call at 1,222 with BOA/Merrill Lynch, Goldman Sachs and UBS getting it nearly right. However, earnings surprised the analysts as the final EPS turned out to be much higher at $84 as against the expected EPS of $76.

A New era of protectionism or a vital market stabilizer clause?

The other day someone asked about the probability and time frame within which GCC countries (especially Saudi Arabia) are likely to be included in the MSCI EM index, the most widely followed emerging market index in the world. However, what happened recently is quite the contrary to this expectation. MSCI decided to discontinue Saudi Arabia in its MSCI GCC index effective September 2010. This sent fund managers in a tailspin as they now have to replace their benchmarks with S&P GCC index.

What really happened?

Here is the version gleaned from public space and private conversations. Tadawul (the official stock exchange for Saudi Arabia) required the right to prohibit (veto) MSCI from licensing the index to third parties involved in constructing financial products like ETF’s, future contracts, options and derivatives in order to prevent unexpected flow of money (both inwards and outwards). In other words, they do not want Saudi market to get swamped by “hot money”. Simply put, Tadawul wanted MSCI to check with them before MSCI can license its MSCI GCC index to any money manager. Also, Tadawul would have the right to refuse the licensing if it believes that the money may be “hot”.

However, MSCI feels that it is restrictive and anti-competitive and has never done this in its years of existence.  

The competitors (S&P and Dow Jones) were quick to jump in to fill the vacuum left by MSCI.

This may pass up as trivia given the fact that foreign investors (The term Foreign investors in this context does not include GCC nationals and residents of KSA) capture a small percentage of the total value traded (Figure -1). In August 2008 the Kingdom allowed foreigners to enter the Saudi stock market through Equity swap agreements with authorized persons. However, foreign investors are limited to the economic gains of the stock with no voting rights. Moreover the Saudi Capital market authority has the right to discontinue authorized persons from entering into a swap agreement and could impose limitations on each agreement or on beneficial investors.

Figure 1- percentage of foreign investors based on value trade

Source: the Capital Market Authority, KSA

It is not uncommon for stock markets to have very strict restrictions on foreign investment given the many episodes of how “hot money” killed some markets in the past. However, what Saudi Arabia needs today is more institutional presence and investment and not less. As such we have seen how liquidity dried up during this year. Also, Saudi market has been the traditional stronghold of speculative retail investors and this action will maintain that status quo.

Being part of MSCI EM index looks like a distant dream now…

Sometime back we created this historical chart depicting oil price and Kuwait stock index since 1994. Last time when we checked this in 2008, the relationship showed a historical correlation of more than 90%. A plain look at the chart would also make one feel that they are not two different lines. (see chart)

 
However what caught our attention is the recent divergence between oil price and KSE Index.  While the long-term correlation (since 1994) stands at 93%, the last five years correlation is placed at 75%. A simple linear regression model (with oil price as independent variable) based on last five year’s data suggests the following:

In other words, the current index (at 7562) is at a discount of nearly 45% given the current oil price of USD80. Alternatively, the current index factors an oil price of only USD40 as against the current oil price of USD80.

Has something happened to Kuwait market that the strong relationship with oil price is slowly breaking away? Or does this spell a classic market opportunity? If the former is true, then the index will never close the 30% gap. If the latter is true, a USD100 oil price would mean an index level of 12,729 (68% higher from the current level). If the current index factors an oil price of only USD40, the downside risk appears minimal. However, if the 30% gap reflects fundamental structural weakness created by the financial crisis, then we may need more and more oil price to see the index make further moves.

In the past a strong and increasing oil price directly resulted in increased liquidity in the banking system passing finally on to end investors in the form of loans/credit. This meant money available for speculation and trading. However, in the current scheme of things a strong oil price will still create liquidity but may not create the same “pass through” effect given the fact that banks have turned more risk averse. It may also be worth noting that there are more negative catalysts than positive ones such as the corporate issues (Agility, Investment Dar, Global, Zain etc) in addition to the regulatory/political climate which have negative implications on investor sentiment. Also, lack of transparency is an issue raising negative investor sentiment. The market always had weak transparency but investors tend to care about it less in “good times” and given that the last couple of years have been bad, lack of transparency has been more of a negative catalyst than usual Hence, in our assessment, the discount is here to stay though the extent (30%) can be debated. So pray for more oil price.

Or will economic recovery in the US and a strengthening Dollar lead to Gold falling out of favor with investors?

Gold has traditionally been used as a hedging device against a weakening US Dollar, low interest rates and inflationary fears. These conditions prevailed in 2009, leading Gold to reach a record high of USD1,227.50. Additionally, the Reserve Bank of India announced a purchase of 200 ton of Bullion from the IMF, a symbol to the lack of confidence in the greenback. Gold, which typically moves inversely to the dollar, rose 24% last year as the dollar fell 4.2%. Analysts predict that the price may reach another all-time high this year. Analysts surveyed by the London Bullion Market Association said that in 2010, gold will average USD1,199, up 23% from last year, according to the average forecast in a survey of 26 traders and analysts.

As global economic and market conditions continued to be murky and unstable, Gold saw a spectacular rise in popularity, gaining 10% in November alone to close out the year with a 24% annual gain versus 6% for 2008. According to Mr. Raghu Mandagolathur, Head of Research, the sharp rise in gold indicates the cloudy global status in terms of pulling out of recession. In spite of huge fiscal and monetary stimuli being enacted so far, the world is still a place with significant imbalances. Such scenarios lead to a favoring of Gold and other commodities as stores of value or “safe havens” which leads to a direct increase in demand. “The demand side factor is further compounded by aggressive buying by some central banks (e.g. India). On the other hand, supply is constrained. It is estimated that new supply will significantly reduce from 2010 onwards. Recycling from scrap as well as government sales are expected to be muted thus constraining supply further. Strong demand and weak supply is further helped by low interest rates, which are a plus for any commodity investment.” (Mr. Raghu Mandagolathur)

However, gold is not an asset class. Prices will tend to come back the moment there is clarity on the global economy. Till then the gold price may sway due to intense speculation. (Mr. Raghu Mandagolathur) Gold is likely to see another year of gains in 2010, but not as “spectacular” as 2009, according to Mr. Roshan Chutkey, who tracks international markets. He cites “considerable uncertainty surrounding USD movement for the year” in addition to a “general consensus that the greenback is in for a long-term depreciation” as propellers of Gold prices gains in the coming year. “Gold has averaged USD950 for 2009 with the current prices hovering around USD1,150; I expect gold to swing between USD1000 and USD1300 for 2010.” (Mr. Raghu Mandagolathur)

-       Compiled and edited by Ms. Layla Al-Ammar, Investment Analyst, Research

The Markaz Analysts Club is an initiative launched by Markaz with an aim to collate the many varied and diverse viewpoints of Markaz analysts in an informal setting in order to share with the public the depth and breadth of analyst knowledge power within Markaz. On a periodical basis, a question concerning the topic/s of the day is posed to our analysts spanning various departments within Markaz (from Real Estate to Oil & Gas to Corporate Finance etc); these analysts’ responses are then compiled into a brief opinion piece for public viewing.

Will GCC markets recover during 2010?
GCC stock markets have terribly underperformed other markets, both Emerging and Developed, during 2009. The overall MSCI GCC Index gained just 18% against 73% for Emerging markets and 27% for MSCI World. This depressed market activity comes in spite of decent crude oil prices (IPE Brent is up 85% for the year), low inflation (down to 2.5% in 2009 from 11% in 2008) in addition to fairly comfortable fiscal surpluses across the major economies.

The question then is; given such underperformance, do GCC markets present a good opportunity for 2010? And are we likely to see a recovery in market performance in 2010?

Mr. Ramadoss Venkateshwaran, who specializes in the Real Estate segment, pointed out that the question itself “tempts one to conclude that an upswing rally is due for GCC markets, especially when the region is slowly coming out of internal crises which emerged as a by-product of the global crisis and slowdown.” He notes that what distinguishes frontier markets such as the GCC is in the realm of systemic risks, pointing to events such as Gulf Bank, Saad & Algosaibi and Dubai World as a hallmark for such risks. “Although incidents of such systemic risk events increase during a downturn in all markets, like Lehman Brothers, the lag between the end of a downturn and the end of such incidences is bigger in frontier markets.” He goes on to point out that in the developed world; these events tend to act as precursors to a trough or bottoming out “as the number of such incidences recedes”. However, in frontier markets such as the GCC, such events followed the period in which the IMF and other such agencies had forecasted economic recovery. Consequently, such “risk perceptions have kept prices from rising and I believe that, if the global economy manages to avoid a double dip, as expected by the central consensus forecasts, GCC markets would pose a good upside from current levels as risk perception wanes.” (Mr. Ramadoss Venkateshwaran)

Moving from systemic risks in GCC economies to corporate earnings strength, Mr. Amrith Mukkamala (Senior Analyst, Research) notes that 2010 earnings “are not expected to be significantly robust. We are looking at +6 to +8% growth in earnings at a GCC level. The only country which is expected to witness a significant growth in earnings is Kuwait.” Furthermore, given the outflow of foreign money, he expects external liquidity to be neutral. Mr. Raghu Mandagolathur, S.V.P. for Research, notes that “even during good days, market performance can mostly be attributed to local liquidity and speculation rather than foreign investor interest. Foreign investors still view the GCC as a frontier market with serious limitations including lack of corporate governance, information and research. A good run on oil price may bring back some hedge funds that are keen on quick money but it will take fundamental changes at a market microstructure level to get the attention of quality institutional investors.” Moreover, internal liquidity is expected to be tight with negative investor sentiment due to “low corporate disclosures and comparatively poor corporate governance standards. Thus, in absolute terms I would expect a 15-20% return on MSCI GCC in 2010. This would mean a relative underperformance as compared to the other emerging markets. (Mr. Amrith Mukkamala)” Mr. Pradeep Rajagopalan suggests that rather than viewing the GCC markets as a whole, he would view it as a “barbell with some companies doing very well and some companies posting steep declines”, given that in many markets, it is a select number of companies which drive overall market performance, it would be more prudent for investors to take specific calls on undervalued firms, irrespective of country.

Nearly all analysts noted healthy crude oil prices as a driver for growth in 2010, with an expectation that crude oil prices will remain in the USD 60-80 range, however, Mr. Amrith Mukkamala, points out that the impact of such a range would be neutral for markets. Mr. Raghu Mandagolathur, agrees, noting that “the issue no longer rests with just oil price” and that the GCC is paying a high price for turning a blind eye to “much needed reforms in virtually every aspect of market functioning.” The current financial crisis has thoroughly exposed the gaps and weak spots throughout the GCC. He notes that “lack of CMA, corporate governance failures, family group defaults, banking failures, real estate meltdown, project cancellations, etc loom so large that a mere normal oil price scenario is just not enough to lift spirits.” Strong crude oil prices will undoubtedly strengthen government coffers; however, “successfully transmitting them down the line will need enormous straightening up on many fronts.”

In closing, our analysts believe that recovery will likely be patchy in 2010, Mr. Roshan Chutkey, who tracks international markets, believes that asset managers ought to lower allocation to the GCC in 2010 in favor of other emerging economies, noting that the GCC may provide some 2011 stories, but that he expects the region to be a laggard in 2010 as well. Mr. Raghu Mandagolathur points out that “the reasons why GCC markets underperformed emerging markets in 2009 will still be in force during 2010. Unless oil breaks out to frenzy levels (say above USD150/b), the GCC markets may deliver yet another year of normal returns (defined as anything between 10% to 20%).”

-  Compiled and edited by Ms. Layla Al-Ammar, Investment Analyst, Research

The Markaz Analysts Club is an initiative launched by Markaz with an aim to collate the many varied and diverse viewpoints of Markaz analysts in an informal setting in order to share with the public the depth and breadth of analyst knowledge power within Markaz. On a periodical basis, a question concerning the topic/s of the day is posed to our analysts spanning various departments within Markaz (from Real Estate to Oil & Gas to Corporate Finance etc); these analysts’ responses are then compiled into a brief opinion piece for public viewing.